Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Fundamentals of Strategy - Internal Analysis

Itai Ater
School of Management
Tel Aviv University

January 4, 2016

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Fedex - this week and guest lecture on Friday

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

The Goal

A strategy is feasible if and only if the firm is able to make

the necessary adjustments.
The feasibility depends on the internal resources and the
capabilities of the firm
The analysis that describes the firm, its capabilities and its
ability to adjust is the internal analysis.

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

The Discussion

Less structured than the external analysis discussion.

First part - the firms horizontal and vertical boundaries
(interface with the markets and other firms).
Second part- internal characteristics of the firm.

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Introduction

Horizontal boundaries refer to the depth, variety and

magnitude of the firms products line.
We will discuss three determinants of the horizontal
boundaries:
Economies of Scale.
Learning curve.
Economies of Scope.

Economies of scale, economies of scope and learning curve

are growth engines for the firm.
The firm must actively take advantage of these properties
(For instance, in pricing and entry decisions)

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Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Economies of Scale

Double or Imitate?
Increasing returns to scale imply decreasing average costs.
Decreasing returns to scale (dis-economies of scale) is the
opposite.

Introduction

Horizontal Boundaries

Vertical Boundaries

Increasing Economies of Scale

Reasons for increasing economies of scale:

Fixed costs.
Economies of Utilization.
Specialization.
Bargaining power (Purchasing).
Deep pockets.
Clientele (Advertising, R & D).

Internal Characteristics

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Decreasing Economies of Scale

Reasons for decreasing economies of scale:

Diminishing marginal product.
Management costs.
Antitrust.
Higher wages.
Conflicting out.

The average costs curve is usually U-shaped in the short

term and L-shaped in the long term.

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Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Learning Curve

Advantage due to experience.

Learning curve exists if higher aggregate (over time)
production leads to lower average costs or to better quality.
It is fundamentally different from economies of scale.
Blue collar factory - economies of scale and no learning
curve??.
Law firm - learning curve with no economies of scale.

Learning curve depends on personnel policy.

How much learning is embedded in the organization?

Introduction

Horizontal Boundaries

Vertical Boundaries

Economies of Scope

Mix or Separate?
TC(Qx,Qy) < TC(Qx,0) +TC(0,Qy).
Reasons for economies of scope:
Leveraging core competencies.
Diversification of risk.

Internal Characteristics

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Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

The Cons and Pros of Branding

Pros: with a strong brand name it is easier to introduce new

products (umbrella effect)
Cons: depends on the legacy (You and Mega); easier to go
after you (Tnuva vs. Unilever)

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Vertical Boundaries

Internal Characteristics

Strategic Fit
Economies of scope are similar to production synergies,
which result in lower costs.
Strategic fit is a similar concept which applies to
organizational practices.
Organizational practice is the execution of a plan or an idea
in organization.
Synergies arise when the benefits of one practice are
enhanced when other practices are implemented as well.
Achieving strategic fit makes copying of only a subset of
these organizational procedures by rivals unproductive
Thus, strategic fit is essential for long term competitive
advantage
An example - Airborne Express

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Vertical Boundaries

Internal Characteristics

Southwest Airlines - Example for Strategic Fit

Goal: A major domestic airline that provides primarily
shorthaul, high-frequency, point-to-point, low-fare service.
1

2
3
4

6
7

To keep costs low, airplanes are in the air most of the time:
Average aircraft has 7 flights a day and average duration is
1:46 hours. Average. time at gate is 25 minutes (almost 3
hours a day)
Short-haul flights make saving time on the ground effective.
No food to keep cost low and minimize time at the airport.
Most of passengers fly non-stop - there is no need to
transfer baggage which is costly and slow and increases the
chance of losing baggage
No assigned seats to make check in faster and save cost on
ticketing
Use secondary airports to avoid congestion
Boeing 737 - only one type of aircraft saves scheduling,
maintenance, and training costs

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Introduction

Vertical boundaries refer to the role of the firm in the value

chain.
The firms goal is to focus on value creating activities.
Other activities should be taken by other firms.
Analyzing the value chain should reveal the value creating
activities.

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Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Value Chain
A value chain is a string of companies or players working
together (usually sequentially) to satisfy market demand for a
particular product (examples: CSD, entertainment).

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Internal Characteristics

Vertical Integration and Outsourcing

Vertical integration occurs when two consecutive firms in the

value chain merge.
Outsourcing occurs when a firm delegates one of its
operations to an outside supplier.
Often, the relevant question is make (vertically integrate) or
buy (outsource)
Ronald Coase, won the Nobel prize in economics partially
for raising this question

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Vertical Boundaries

Internal Characteristics

Vertical Integration (1)

Considerations in favor of vertical integration

Improving coordination and control (when quick changes are

necessary and the environment is uncertain).
Cutting agency costs and transaction costs (e.g. logistics).
Utilizing complementarities.
Reducing leakage of valuable information.

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Internal Characteristics

Vertical Integration (2)

Considerations in favor of vertical integration

Solving the hold-up problem:

A firm that relies on assets owned by another party may
become dependent on that partys cooperation in the future
(that party may gain the ability to hold-up the firm).
E.g. Concentrate producers and bottlers, Babylon and
Microsoft.

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Vertical Boundaries

Internal Characteristics

The Hold-Up Problem

The threat of opportunistic behavior (or hold-up) depends on

the alternatives that a firm faces. The higher the specificity
of an asset the larger the threat for hold-up.
To avoid being hold-up, an employee is more likely to invest
in general, rather than specific, skills
To reduce the opportunistic behavior firms can vertically
integrate. For instance, electric utilities integration into
coal-mining.
Often, long term contracts are also useful in reducing
hold-up concerns, though contracts cannot foresee all future
contingencies.

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Vertical Boundaries

Internal Characteristics

Vertical Integration (3)

Considerations in favor of vertical integration

Raising rivals costs:

By Integrating, the firm can control essential resources, and
prevent rivals access to these resources
Examples: limited shelf space
Controlling Zomet Sfarim helps books published by
Zmora-Bitan
Electronics retailers are owned by electronics importers

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Outsourcing
Considerations in favor of outsourcing

Reduce and control operating costs (smaller organization).

Exploit scale and knowledge by other firms (e.g. proprietary
knowledge, scale economies, specialization).
Get rid of operations that do not provide competitive
advantage (improve focus).
Free up internal resources.
Maintain level of flexibility, for instance in satisfying changing
tastes and requirements by consumers

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Internal Characteristics

Hybrid Organizations

Typically, firms choose to outsource certain activities while

performing others.
In some cases, firms choose to mix the same activity,
performing internally and through an external party
For instance, retail chains often sell through in-house
operations and through franchisees.
Why?

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Internal Characteristics

Ownership Structure in the Airline Industry

In the US airline industry, large airlines do not operate

themselves all flights but rely on small-regional carriers to do
it for them.
Some large airlines contract with the regional carriers and
others choose to own the regional carrier (vertically
integrate).
Can we explain the different patterns of ownership?

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Internal Characteristics

Franchising

In franchised agreements, an independent owner/operator

signs a long-term contract with a chain
According to a typical contract - the contract lasts for several
years and the franchisee pays royalties to the chain
The chain helps in training employees, in setting standards
(quality, menu items) and by providing an established
reputation/brand name
Why should an established chain choose to operate using
franchisees? What do the franchisees gain?
What are the risks for the franchisee and for the chain? Are
their incentives completely aligned?

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Vertical Boundaries

Internal Characteristics

Sonol Dor Alon Merger

In 2005, Dor-Alon planned to acquire Sonol and the two

parties filed the antitrust authority a petition to merge
Before the proposed merger there were 4 big fuel
distributors: Paz (240), Delek (220), Sonol (200) and Dor
Alon (150) and few other minor suppliers.
Should the antitrust authority allow or block the merger?
What is the relevant market to analyze?
Does the fact the Paz integrated into the oil refinery segment
(Ashdod) affect your decision?

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Introduction

We briefly discuss the internal characteristics of the firm.

Topics:
Performance.
Incentives.
Capabilities.
Structure.

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Vertical Boundaries

Internal Characteristics

Performance

Does the firm live up to its potential?

How to measure performance?
Should be analyzed at each phase of the value chain.
Performance has random component (luck?).
Performance should be judged by the ex-ante information.
Comparison to other firms (survival bias).
Comparison to the firms past (equal terms).

Possible indices (validity):

NPV
Stock price.
Sales.
Market share.
Return on Assets (operating profits to total assets).

Introduction

Horizontal Boundaries

Vertical Boundaries

Operational profitability in the Food Industry

Internal Characteristics

Introduction

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Internal Characteristics

Gross and operational and profitability - example

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Internal Characteristics

Incentives

Implementation of strategy depends on motivation

Incentives - wage, benefits, promotion, reputation
Should the firm induce effort or performance?
Effort is unobservable (luck, group effort) so focus on
performance, but..
Measurement is costly and often inaccurate:
Subjective evaluations require substantial resources
Inaccurate measurement distort efforts

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Vertical Boundaries

Internal Characteristics

Designing Performance Measures

The scope of the performance measure:

Broad measures of performance, e.g. share price involve
more risk for the employee
Narrow measures of performance, e.g. number of units
produced by an employee (distort incentives when
multi-tasking)

The stronger is the dependency of the incentive on

outcome, the stronger is the incentive (but also, the
uncertainty increases).
Some incentives are relative and some are absolute. Which
is better?

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Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Capabilities
The main issue: What is the firm capable of?
The firms capabilities result from its assets and advantages.
The firms assets:
Material assets.
Organizational assets (employment relations, culture,
reputation).
Technological assets (knowledge, patents).

The firms possible advantages:

Managerial capabilities (e.g. movement to emerging
markets).
Functional capabilities (e.g. R&D, certain processes).
An advantage is more significant if it is robust to imitation.
An advantage may or may not be transferable.
An activity which is not advantageous should be considered
for outsourcing.

Introduction

Horizontal Boundaries

Vertical Boundaries

Internal Characteristics

Structure

An internal analysis must recover the formal and informal

structure of the firm.
The main issue: Does the firms internal structure serves its
goals? Is there strategic alignment between strategy and
organizational structure?
The selected strategy should dictate the organizational
structure (however, organizational structure is hard to
change).